On Monday (February 4th), Blockchain startup Blockstream announced that its new open-source "Proof of Reserves" tool could help centralized cryptocurrency exchanges prove their BTC balances to third parties (such as auditors). And in the wake of the huge disaster at Canada's QuadrigaCX exchange, the desperate need for such a tool is even easier to see.

What Is the Problem Blockstream Is Trying to Solve?

"Bitcoin exchanges are increasingly coming under pressure from users and regulators to prove they are managing their users funds correctly. After so many high-profile hacks over the years (many of which went unnoticed for some time), proving Bitcoin reserves has become an important task for businesses seeking to retain the trust of their customers."

What Is Wrong With Existing Solutions?

"Unfortunately, the few exchanges that are taking steps to prove their Bitcoin balances to third parties use their own in-house solutions to generate their proofs. The variety of approaches makes it difficult for anyone wishing to verify exchange holdings for themselves, as they must familiarize themselves with each individual system, which usually requires some specialist technical knowledge."

Poor Accessibility: "as stated above, due to each exchange taking a DIY approach, proof of reserve solutions are technical and unfamiliar. Users have to figure out how to verify holdings for each exchange they engage with. This leads to more trusting, and less verifying."

Security risks: "proving reserves requires exchange personnel to demonstrate the ownership of private keys associated with exchange wallets. Often this involves the movement of all funds to a new set of addresses—presenting major attack vectors for attackers attempting to compromise storage."

What is Blockstream's Solution and Why Did Blockstream Build It?

"At Blockstream, we’ve been working on a solution to provide a best-practice standard Proof of Reserves for the industry, that offers broad compatibility with the way most Bitcoin exchanges are storing their users’ funds. A BIP has already been submitted to the bitcoin-dev mailing list, and today we’re open-sourcing the development of the tool for feedback from the industry."

Blockstream says this tool was originally developed for their Liquid Network, "a blockchain for exchanges, brokers, and market makers that enables fast, private Bitcoin transactions with other members of the network." In their own words:

"We originally set off to build a solution for Liquid functionaries to prove their Liquid bitcoin (L-BTC) reserves to third-party auditors. But as we researched the project, we quickly realised that existing approaches by exchanges for regular Bitcoin reserves had room for improvement, and that our software had wider applications outside of the Liquid Network."

How Does Blockstream's Proof of Reserves Reserves Tool Work?

"Proof of Reserves allows an exchange to prove how many bitcoin they could spend, without needing to generate a 'live' transaction or exposing themselves to the risks of moving funds.
Using the tool, an exchange first constructs a single transaction which spends all of an exchange’s Bitcoin UTXOs, and adding an extra invalid input. By including one invalid input, the entire transaction is rendered invalid and would be rejected by the network if broadcast. However, the transaction is constructed in such a way that it can still be used as an explicit proof of all the Bitcoin UTXOs spendable by the exchange.
This transaction data can then be shared with anyone that needs to verify reserves. They simply import the data into their own Proof of Reserves client to confirm the exchange’s total holdings and the addresses associated with those holdings. The solution is easy-to-use and accessible to anyone that knows how to run a CLI application."

Currently, this tool "supports both the Bitcoin Core wallet and Trezor, with more integrations on the way (Ledger support coming soon!)." Although the main expected use case for the Proof of Reserves tool is currently centralized crypto exchanges needing to provide a proof of their Bitcoin reserves to auditors for verification purposes, Blockstream hopes that, once they have made some privacy improvements to it, it will eventually also be useful to the users of centralized exchanges.

Some Reactions From Crypto Twitter

Manfred Karrer, Founder of decentralized crypto exchange Bisq:

If you don't hold your keys you don't hold Bitcoin but an IOU. No proof of Reserves needed if you use @bisq_network

CME Looks to Double Bitcoin Futures Limit, but Is This Wise?

The Chicago Mercantile Exchange (CME) has a new request for its regulator, as it looks to double open position limits on bitcoin futures contracts in the face of significant interest.

Nasdaq reports that the CME has already petitioned its regulatory body, the Commodity Futures Trading Commission (CTFC), asking for an increase from 1000 contracts per spot month to 2000 per investor. Each contract represents five BTC, so essentially, at its peak, a single investor's total position may edge towards a monumental 10,000 BTC.

This is in direct response to the contract's recent growth which is currently depicting record levels of activity, citing $370 million being traded per day. A spokesperson for the CME noted that the idea to increase limits was proposed on the continued maturity of the market:

Based on the significant growth and acceptance of our financially-settled CME Bitcoin futures markets, as well as our analysis of the underlying bitcoin market.

However, as Nasdaq writes the increase in the upper limit of positions is somewhat superfluous. As of July, the number of open interest contracts reached an all-time high of just 6100; given this, it seems the CME may be future-proofing.

Open to Manipulation?

However, concerns remain about the limit increase, as without them, the potential for manipulation rises; often to the detriment to the underlying asset. Although, as per the CTFC website, the threat of manipulation from bitcoin futures contracts is "low":

In general, position limits are not needed for markets where the threat of market manipulation is non-existent or very low.

Instead, Nasdaq posited that this might point to a lessening on the CTFC's strict rule of bitcoin; as well as a maturing of the market in general.

Nevertheless, some believe the CME's bitcoin futures contracts do pose a significant threat to the price of BTC; with some suggesting that blatant manipulation continues unchecked within the market.

As reported, there seems to be a correlation between the expiry dates of CME bitcoin futures contracts and a lull in the price point of BTC. In several instances, a significant drop in bitcoin's price has coincided with a closure from the CME. The most recent example of this occurred on Labor Day, September 2, when bitcoin rose an extraordinary 8% shortly after the CME shut.

Crypto analyst, Alex Kruger, highlighted this, noting the large gaps which formed on the CME chart, from the price discrepancy before and after closing.

Whether this is a coincidence or the market is indeed being actively manipulated is as yet unclear. Either way, with the increase of these limits it might be only a matter of time until we know for sure.